Questions for Review

1. The aggregate demand curve represents the negative relationship between the price level and the level of national income. In Chapter 9, we looked at a simplified theory of aggregate demand based on the quantity theory. In this chapter, we explore how the ISLM model provides a more complete theory of aggregate demand. We can see why the aggregate demand curve slopes downward by considering what happens in the ISLM model when the price level changes. As Figure 111(A) illustrates, for a given money supply, an increase in the price level from P1 to P2 shifts the LM curve upward because real balances decline; this reduces income from Y1 to Y2. The aggregate demand curve in Figure 111(B) summarizes this relationship between the price level and income that results from the ISLM model. 91
LM (P = P2) Y2 Y2 Y1 P2 P1 LM (P = P1) Y1 A. The IS LM Model B. The Aggregate Demand Curve r Interest rate B A IS Income, output Income, output P Price level AD Figure 111

CHAPTER 2. The tax multiplier in the Keynesian-cross model tells us that, for any given interest rate, the tax increase causes income to fall by T [ MPC/(1 MPC)]. This IS curve shifts to the left by this amount, as in Figure 112. The equilibrium of the economy moves from point A to point B. The tax increase reduces the interest rate from r1 to r2 and reduces national income from Y1 to Y2. Consumption falls because disposable income falls; investment rises because the interest rate falls. Note that the decrease in income in the ISLM model is smaller than in the Keynesian cross, because the ISLM model takes into account the fact that investment rises when the interest rate falls. 3. Given a fixed price level, a decrease in the nominal money supply decreases real money balances. The theory of liquidity preference shows that, for any given level of income, a decrease in real money balances leads to a higher interest rate. Thus, the LM curve shifts upward, as in Figure 113. The equilibrium moves from point A to point B. The decrease in the money supply reduces income and raises the interest rate. Consumption falls because disposable income falls, whereas investment falls because the interest rate rises.
LM A B Y Income, output Interest rate r

11 Aggregate Demand II

T 1 MPC Y1 Y2 r1 r2 IS2 IS1 MPC 92 Answers to Textbook Questions and Problems Figure 112 B A IS Y Income, output Interest rate r Y1 LM2 LM1 r2 r1 Y2 Figure 113

4. Falling prices can either increase or decrease equilibrium income. There are two ways in which falling prices can increase income. First, an increase in real money balances shifts the LM curve downward, thereby increasing income. Second, the IS curve shifts to the right because of the Pigou effect: real money balances are part of household wealth, so an increase in real money balances makes consumers feel wealthier and buy more. This shifts the IS curve to the right, also increasing income. There are two ways in which falling prices can reduce income. The first is the debt-deflation theory. An unexpected decrease in the price level redistributes wealth from debtors to creditors. If debtors have a higher propensity to consume than creditors, then this redistribution causes debtors to decrease their spending by more than creditors increase theirs. As a result, aggregate consumption falls, shifting the IS curve to the left and reducing income. The second way in which falling prices can reduce income is through the effects of expected deflation. Recall that the real interest rate r equals the nominal interest rate i minus the expected inflation rate e: r = i e. If everyone expects the price level to fall in the future (i.e., e is negative), then for any given nominal interest rate, the real interest rate is higher. A higher real interest rate depresses investment and shifts the IS curve to the left, reducing income.

Problems and Applications

1. a. If the central bank increases the money supply, then the LM curve shifts downward, as shown in Figure 114. Income increases and the interest rate falls. The increase in disposable income causes consumption to rise; the fall in the interest rate causes investment to rise as well. Chapter 11 Aggregate Demand II 93
A B IS Y Income, output Interest rate r LM1 LM2 r1 r2

Y1 Y2 Figure 114

b. If government purchases increase, then the government-purchases multiplier tells us that the IS curve shifts to the right by an amount equal to [1/(1 MPC)]G. This is shown in Figure 115. Income and the interest rate both increase. The increase in disposable income causes consumption to rise, while the increase in the interest rate causes investment to fall. c. If the government increases taxes, then the tax multiplier tells us that the IS curve shifts to the left by an amount equal to [ MPC/(1 MPC)]T. This is shown in Figure 116. Income and the interest rate both fall. Disposable income falls because income is lower and taxes are higher; this causes consumption to fall. The fall in the interest rate causes investment to rise. 94 Answers to Textbook Questions and Problems
LM A B Interest rate Y Income, output Y2 r2 r1 IS2 IS1
G 1 MPC

r Y1 Figure 115 LM A B Interest rate Y Income, output r Y1 IS2 IS1 r2 r1 Y2

MPC 1 MPC T

Figure 116

d. We can figure out how much the IS curve shifts in response to an equal increase in government purchases and taxes by adding together the two multiplier effects that we used in parts (b) and (c): Y = [(1/(1 MPC))]G] [(MPC/(1 MPC))T] Because government purchases and taxes increase by the same amount, we know that G = T. Therefore, we can rewrite the above equation as: Y = [(1/(1 MPC)) (MPC/(1 MPC))]G Y = G. This expression tells us how output changes, holding the interest rate constant. It says that an equal increase in government purchases and taxes shifts the IS curve to the right by the amount that G increases. This shift is shown in Figure 117. Output increases, but by less than the amount that G and T increase; this means that disposable income Y T falls. As a result, consumption also falls. The interest rate rises, causing investment to fall. Chapter 11 Aggregate Demand II 95

LM B A Interest rate Y Income, output r G Y2 IS1 r2 r1 Y1 IS2 Figure 117

2. a. The invention of the new high-speed chip increases investment demand, which shifts the IS curve out. That is, at every interest rate, firms want to invest more. The increase in the demand for investment goods shifts the IS curve out, raising income and employment. Figure 118 shows the effect graphically. The increase in income from the higher investment demand also raises interest rates. This happens because the higher income raises demand for money; since the supply of money does not change, the interest rate must rise in order to restore equilibrium in the money market. The rise in interest rates partially offsets the increase in investment demand, so that output does not rise by the full amount of the rightward shift in the IS curve. Overall, income, interest rates, consumption, and investment all rise. b. The increased demand for cash shifts the LM curve up. This happens because at any given level of income and money supply, the interest rate necessary to equilibrate the money market is higher. Figure 119 shows the effect of this LM shift graphically. 96 Answers to Textbook Questions and Problems
B Interest rate LM Income, output r YY
1

Y
2

IS
2

IS
1

r
1

r
2

A Figure 118 B Interest rate Income, output r YY

2

Y
1

IS r
2

r
1

LM
2

LM
1

Figure 119

The upward shift in the LM curve lowers income and raises the interest rate. Consumption falls because income falls, and investment falls because the interest rate rises. c. At any given level of income, consumers now wish to save more and consume less. Because of this downward shift in the consumption function, the IS curve shifts inward. Figure 1110 shows the effect of this IS shift graphically. Income, interest rates, and consumption all fall, while investment rises. Income falls because at every level of the interest rate, planned expenditure falls. The interest rate falls because the fall in income reduces demand for money; since the supply of money is unchanged, the interest rate must fall to restore money-market equilibrium. Consumption falls both because of the shift in the consumption function and because income falls. Investment rises because of the lower interest rates and partially offsets the effect on output of the fall in consumption. Chapter 11 Aggregate Demand II 97
B Interest rate LM Income, output r Y1 Y2 Y IS2 IS1 r1 r2 A Figure 1110

3. a. The IS curve is given by: Y = C(Y T) + I(r) + G. We can plug in the consumption and investment functions and values for G and T as given in the question and then rearrange to solve for the IS curve for this economy: Y = 200 + 0.75(Y 100) + 200 25r + 100 Y 0.75Y = 425 25r (1 0.75)Y = 425 25r Y = (1/0.25) (425 25r) Y = 1,700 100r. This IS equation is graphed in Figure 1111 for r ranging from 0 to 8. b. The LM curve is determined by equating the demand for and supply of real money balances. The supply of real balances is 1,000/2 = 500. Setting this equal to money demand, we find: 500 = Y 100r. Y = 500 + 100r. This LM curve is graphed in Figure 1111 for r ranging from 0 to 8. c. If we take the price level as given, then the IS and the LM equations give us two equations in two unknowns, Y and r. We found the following equations in parts (a) and (b): IS: Y = 1,700 100r. LM: Y = 500 + 100r. Equating these, we can solve for r: 1,700 100r = 500 + 100r 1,200 = 200r r = 6. Now that we know r, we can solve for Y by substituting it into either the IS or the LM equation. We find

Y = 1,100. Therefore, the equilibrium interest rate is 6 percent and the equilibrium level of output is 1,100, as depicted in Figure 1111. 98 Answers to Textbook Questions and Problems
IS LM 500 1,100 1,700 Y 0 6 8 r Interest rate Income, output Figure 1111

d. If government purchases increase from 100 to 150, then the IS equation becomes: Y = 200 + 0.75(Y 100) + 200 25r + 150. Simplifying, we find: Y = 1,900 100r. This IS curve is graphed as IS2 in Figure 1112. We see that the IS curve shifts to the right by 200. By equating the new IS curve with the LM curve derived in part (b), we can solve for the new equilibrium interest rate: 1,900 100r = 500 + 100r 1,400 = 200r 7 = r. We can now substitute r into either the IS or the LM equation to find the new level of output. We find Y = 1,200. Therefore, the increase in government purchases causes the equilibrium interest rate to rise from 6 percent to 7 percent, while output increases from 1,100 to 1,200. This is depicted in Figure 1112. Chapter 11 Aggregate Demand II 99
500 1,100 1,200 LM 200 1,700 1,900 Y 0 6 7 r Interest rate Income, output IS2 IS1 8 Figure 1112

e. If the money supply increases from 1,000 to 1,200, then the LM equation becomes: (1,200/2) = Y 100r, or Y = 600 + 100r. This LM curve is graphed as LM2 in Figure 1113. We see that the LM curve shifts to the right by 100 because of the increase in real money balances. To determine the new equilibrium interest rate and level of output, equate the IS curve from part (a) with the new LM curve derived above: 1,700 100r = 600 + 100r 1,100 = 200r 5.5 = r. Substituting this into either the IS or the LM equation, we find Y = 1,150. Therefore, the increase in the money supply causes the interest rate to fall from 6

percent to 5.5 percent, while output increases from 1,100 to 1,150. This is depicted in Figure 1113. f. If the price level rises from 2 to 4, then real money balances fall from 500 to 1,000/4 = 250. The LM equation becomes: Y = 250 + 100r. 100 Answers to Textbook Questions and Problems
IS 500 600 1,100 1,150 1,700 Y 0 r 6.0 5.5 Interest rate Income, output
100

LM1 LM2 Figure 1113

As shown in Figure 1114, the LM curve shifts to the left by 250 because the increase in the price level reduces real money balances. To determine the new equilibrium interest rate, equate the IS curve from part (a) with the new LM curve from above: 1,700 100r = 250 + 100r 1,450 = 200r 7.25 = r. Substituting this interest rate into either the IS or the LM equation, we find Y = 975. Therefore, the new equilibrium interest rate is 7.25, and the new equilibrium level of output is 975, as depicted in Figure 1114. g. The aggregate demand curve is a relationship between the price level and the level of income. To derive the aggregate demand curve, we want to solve the IS and the LM equations for Y as a function of P. That is, we want to substitute out for the interest rate. We can do this by solving the IS and the LM equations for the interest rate: IS: Y = 1,700 100r 100r = 1,700 Y. LM: (M/P) = Y 100r 100r = Y (M/P). Combining these two equations, we find 1,700 Y = Y (M/P) 2Y = 1,700 + M/P Y = 850 + M/2P. Since the nominal money supply M equals 1,000, this becomes Y = 850 + 500/P. Chapter 11 Aggregate Demand II 101
250 r IS 7.25 6.0 Interest rate 0 600 975 1,200 1,700 Y 250 Income, output LM2 LM1 1,100 Figure 1114

This aggregate demand equation is graphed in Figure 11 15. How does the increase in fiscal policy of part (d) affect the aggregate demand curve? We can see this by deriving the aggregate demand curve using the IS equation

from part (d) and the LM curve from part (b): IS: Y = 1,900 100r 100r = 1,900 Y. LM: (1,000/P) = Y 100r 100r = Y (1,000/P). Combining and solving for Y: 1,900 Y = Y (1,000/P), or Y = 950 + 500/P. By comparing this new aggregate demand equation to the one previously derived, we can see that the increase in government purchases by 50 shifts the aggregate demand curve to the right by 100. How does the increase in the money supply of part (e) affect the aggregate demand curve? Because the AD curve is Y = 850 + M/2P, the increase in the money supply from 1,000 to 1,200 causes it to become Y = 850 + 600/P. By comparing this new aggregate demand curve to the one originally derived, we see that the increase in the money supply shifts the aggregate demand curve to the right. 4. a. The IS curve represents the relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services. That is, it describes the combinations of income and the interest rate that satisfy the equation Y = C(Y T) + I(r) + G. 102 Answers to Textbook Questions and Problems
P 4.0 2.0 1.0 0.5 0 975 1,100 1,350 1,850 Y Price level Income, output Figure 1115

If investment does not depend on the interest rate, then nothing in the IS equation depends on the interest rate; income must adjust to ensure that the quantity of goods produced, Y, equals the quantity of goods demanded, C + I + G. Thus, the IS curve is vertical at this level, as shown in Figure 1116. Monetary policy has no effect on output, because the IS curve determines Y. Monetary policy can affect only the interest rate. In contrast, fiscal policy is effective: output increases by the full amount that the IS curve shifts. b. The LM curve represents the combinations of income and the interest rate at which the money market is in equilibrium. If money demand does not depend on the interest rate, then we can write the LM equation as M/P = L(Y). For any given level of real balances M/P, there is only one level of income at which the money market is in equilibrium. Thus, the LM curve is vertical, as shown in Figure 1117. Fiscal policy now has no effect on output; it can affect only the interest rate. Monetary policy is effective: a shift in the LM curve increases output by the full amount of the shift. c. If money demand does not depend on income, then we can write the LM equation as M/P = L(r). Chapter 11 Aggregate Demand II 103
r IS Interest rate

LM YY Income, output Figure 1116 LM IS YY Income, output r Interest rate

For any given level of real balances M/P, there is only one level of the interest rate at which the money market is in equilibrium. Hence, the LM curve is horizontal, as shown in Figure 1118. Fiscal policy is very effective: output increases by the full amount that the IS curve shifts. Monetary policy is also effective: an increase in the money supply causes the interest rate to fall, so the LM curve shifts down, as shown in Figure 1118. d. The LM curve gives the combinations of income and the interest rate at which the supply and demand for real balances are equal, so that the money market is in equilibrium. The general form of the LM equation is M/P = L(r, Y). Suppose income Y increases by $1. How much must the interest rate change to keep the money market in equilibrium? The increase in Y increases money demand. If money demand is extremely sensitive to the interest rate, then it takes a very small increase in the interest rate to reduce money demand and restore equilibrium in the money market. Hence, the LM curve is (nearly) horizontal, as shown in Figure 1119. 104 Answers to Textbook Questions and Problems
LM1 LM2 IS Y Income, output r Interest rate Figure 1118 LM IS Y Income, output r Interest rate Figure 1119

An example may make this clearer. Consider a linear version of the LM equation: M/P = eY fr. Note that as f gets larger, money demand becomes increasingly sensitive to the interest rate. Rearranging this equation to solve for r, we find r = (e/f)Y (1/f)(M/P). We want to focus on how changes in each of the variables are related to changes in the other variables. Hence, it is convenient to write this equation in terms of changes: r = (e/f)Y (1/f)(M/P). The slope of the LM equation tells us how much r changes when Y changes, holding M fixed. If (M/P) = 0, then the slope is r/Y = (e/f). As f gets very large, this slope gets closer and closer to zero. If money demand is very sensitive to the interest rate, then fiscal policy is very effective: with a horizontal LM curve, output increases by the full amount

that the IS curve shifts. Monetary policy is now completely ineffective: an increase in the money supply does not shift the LM curve at all. We see this in our example by considering what happens if M increases. For any given Y (so that we set Y = 0), r/(M/P) = ( 1/f); this tells us how much the LM curve shifts down. As f gets larger, this shift gets smaller and approaches zero. (This is in contrast to the horizontal LM curve in part (c), which does shift down.) 5. To raise investment while keeping output constant, the government should adopt a loose monetary policy and a tight fiscal policy, as shown in Figure 11 20. In the new equilibrium at point B, the interest rate is lower, so that investment is higher. The tight fiscal policyreducing government purchases, for exampleoffsets the effect of this increase in investment on output. Chapter 11 Aggregate Demand II 105
A B Y r Interest rate IS1 Income, output r1 r2 Y1 LM2 LM1 IS2 Figure 1120

The policy mix in the early 1980s did exactly the opposite. Fiscal policy was expansionary, while monetary policy was contractionary. Such a policy mix shifts the IS curve to the right and the LM curve to the left, as in Figure 1121. The real interest rate rises and investment falls. 6. a. An increase in the money supply shifts the LM curve to the right in the short run. This moves the economy from point A to point B in Figure 1122: the interest rate falls from r1 to r2, and output rises from Y to Y2. The increase in output occurs because the lower interest rate stimulates investment, which increases output. Since the level of output is now above its long-run level, prices begin to rise. A rising price level lowers real balances, which raises the interest rate. As indicated in Figure 1122, the LM curve shifts back to the left. Prices continue to rise until the economy returns to its original position at point A. The interest rate returns to r1, and investment returns to its original level. Thus, in the long run, there is no impact on real variables from an increase in the money supply. (This is what we called monetary neutrality in Chapter 4.) 106 Answers to Textbook Questions and Problems
Income, output Y1 r2 r1 IS IS2 1 LM2 LM1 A B Y r Interest rate Figure 1121 Figure 10-19 A B IS

Y r Interest rate r1 LM2 Y= Y Income, output LM1 Y Y2 r2 Figure 1122

b. An increase in government purchases shifts the IS curve to the right, and the economy moves from point A to point B, as shown in Figure 11 23. In the short run, output increases from Y to Y2, and the interest rate increases from r1 to r2. The increase in the interest rate reduces investment and crowds out part of the expansionary effect of the increase in government purchases. Initially, the LM curve is not affected because government spending does not enter the LM equation. After the increase, output is above its long-run equilibrium level, so prices begin to rise. The rise in prices reduces real balances, which shifts the LM curve to the left. The interest rate rises even more than in the short run. This process continues until the long-run level of output is again reached. At the new equilibrium, point C, interest rates have risen to r3, and the price level is permanently higher. Note that, like monetary policy, fiscal policy cannot change the long-run level of output. Unlike monetary policy, however, it can change the composition of output. For example, the level of investment at point C is lower than it is at point A. c. An increase in taxes reduces disposable income for consumers, shifting the IS curve to the left, as shown in Figure 1124. In the short run, output and the interest rate decline to Y2 to r2 as the economy moves from point A to point B. Chapter 11 Aggregate Demand II 107
C B A Y r Interest rate r3 r2 r1 IS1 IS2 LM2 LM1 Income, output Y= Y Y Y2 Figure 1123 A B C Y r Interest rate Y= Y LM2 LM1 IS1 IS2 Income, output YY2

r2 r3 r1 Figure 1124

Initially, the LM curve is not affected. In the longer run, prices begin to decline because output is below its long-run equilibrium level, and the LM curve then shifts to the right because of the increase in real money balances. Interest rates fall even further to r3 and, thus, further stimulate investment and increase income. In the long run, the economy moves to point C. Output returns to Y, the price level and the interest rate are lower, and the decrease in consumption has been offset by an equal increases in investment.